Ch5-9-theories - master budget PDF

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CHAPTER 4BONDS PAYABLEQuestion 4-What is bond?Answer 4-A bond is a formal unconditional promise, made under seal, to pay a specified sum of money at a determinable future date, and to make periodic interest payments at a stated rate until the principal sum is paid.In simple language, a bond is a con...

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CHAPTER 4 BONDS PAYABLE Question 4-1 What is bond? Answer 4-1 A bond is a formal unconditional promise, made under seal, to pay a specified sum of money at a determinable future date, and to make periodic interest payments at a stated rate until the principal sum is paid. In simple language, a bond is a contract of debt whereby one party called the borrower or issuer borrows funds from another party called the investor or bondholder. A bond indenture or deed of trust is the document which shows in detail the terms of the bond and the rights and duties of the borrower and other parties to the contract. QUESTION 4-2 Define or describe the following types of bondsTerm bonds 1. Serial bonds 2. Mortgage bonds 3. Collateral trust bonds 4. Debenture bonds 5. Registered bonds 6. Coupon or bearer bonds 7. Convertible bonds 8. Callable bonds 9. Guaranteed bonds 10. Junk bonds 11. Commodity-backed bonds

Answer 4-2 1. 2. 3. 4. 5. 6.

Term bonds with a single date of maturity/ Serial bonds are bonds with series of maturity dates or bonds that mature installments. Mortgage bonds are bonds secured by mortgage of real properties. Collateral trust bonds are bonds secured by investments in stocks and bonds. Debenture bonds are bonds without collateral security. Registered bonds require the registration of the name of the bondholder on the books of corporation. Consequently, when the bondholder sells a bond, the old bond certificate is surrendered and a new bond certificate is issued to the buyer. Interest is paid periodically to the bondholder of record. 7. Coupon or bearer bonds- the name of the bondholder is not registered. Accordingly, interest paid periodically to the bearer of the bond or the person submitting a detachable interest coupon. 8. Convertible bonds are bonds that can be exchange for equity shares of issuing entity. 9. Callable bonds are bonds that can be called in for payment before the maturity date. 10. Guaranteed bonds are bonds issued whereby another party promises to make payment if the borrower fails to do. 11. Junk bonds are high risk and high yield bonds issued by entities that are heavily indebted or otherwise in weak financial position. 12. Commodity-backed bonds are bonds which are redeemable in terms of commodities such as oil or precious metals.

QUESTION 4-3 Explain a “ premium on bonds payable”. ANSWER 4-3 If the sales price of the bonds is more that the face value of the bonds, the bonds are said to be sold at a premium. The “premium on bonds payable” is in effect gin on the payable the issuing entity or borrower, because it receives more than what it is obligated to pay under the bond issue. The obligation of the issuing entity is limited only to the face value of the bonds. The premium on bonds payable, however, is not treated as an outright gain but amortized over the life of the bond by debiting premium on the bonds payable and crediting interest expense. QUESTION 4-4 Explain a “discount on the bonds payable”.

ANSWER 4-4 If the sales price of the bonds is less than the face value of the bonds, the bonds are said to be sold at a discount. The “discount on bonds payable” is in effect a loss to the issuer entity because it receives less than what it is obligated to pay which is equal to the face value. However, the discount on the bonds payable is not treated outright loss but amortized over the life of the bonds by debiting interest expense and crediting discount on bonds payable. QUESTION 4-5 Explain “bond issue costs” ANSWER 4-5 Bond issue cost or “transacti0on costs” are incremental costs that are directly attributable to the issue of bonds payable. Such cost include printing and engraving cost, promotion cost legal and accounting fee, registration fee with regulatory authorities, commission paid to agents and underwrites and other similar charges. Bond issue costs are not treated as outright expenses but amortized over the life of the bond issue in a manner similar to that used for discount on bonds payable. Bond issue costs are conceived as cost of borrowing and therefor will increase interest expense. The amortization of bond issue costs is recorded by debiting interest expense and crediting bond issue costs. QUESTION 4-6 Explain the measurement of bonds payable. ANSWER 4-6 PFRS 9, paragraph 5.1.1 provides that bonds payable not designated at fair value minus transaction cost that are directly attributable to the issue of the bonds payable. The fair value of the bonds payable is equal to the present value of the future cash payments to settle the bond liability. Bond issue costs shall be deducted from the fair value or issue price of the bonds payable in measuring initially the bonds payable.

However, if the bonds are designated and accounted for “at fair value through profit or loss” the bond issue costs are treated as expense immediately. Actually, the fair value of the bonds payable is the same as the issue price or net proceeds from the issue of the bonds excluding accrued interest. QUESTION 4-7 Explain the subsequent measurement of bonds payable. ANSWER 4-7 PFRS 9, paragraph 5,3,1, provides that after initial recognition, bonds payable shall be measured either: a. At amortized cost, using the effective interest method b. At fair value through profit or loss QUESTION 5-8 Explain the “amortized cost” of bonds payable. ANSWER 4-8 The “amortized cost” of bonds payable is the amount at which the bond liability is measured initially minus principal repayment, plus or minus the cumulative amortization using the effective interest method of any difference between the initial amount and the maturity amount. Simply stated, the difference between the face amount and the present value is either discount of premium on the issue of the bonds payable. Accordingly, discount on bonds payable and bond issue cost are presented as deduction from bond payable is an addition of bonds payable.

QUESTION 4-9 Explain the “fair value option” of measuring bonds payable. ANSWER 4-9 PFRS 9, paragraph 4.2.2 provides that at initial recognition bonds payable may be irrevocably designated as at fair value through profit or loss.

In other words, under fair value option, the bonds payable shall be measured initially at fair value and remeasured at every year-end at fair value and any changes in fair value are recognized in profit or loss. There is no more amortization of bond issue cost, bonds discount and bond premium. As a matter of fact, interest expense is recognized using the nominal or stated interest rate and not the effective interest rate. QUESTION 4-10 On January 1, 2013 an entity issued bonds with face amount of P5,000,000 and 12% stated rate for P5,379,100. The bonds are sold to yield 10%. Interest is payable annually on December 31. The entity paid bond issue cost of P100,000. On December 31,2013, the fair value of the bonds is determined to be P5,300,000. Prepare the journal entries for 2013 assuming the entity elects the fair valkue option of measuring the bonds payable. ANSWER 4-10 Jan. 1 Cash

5,379,100 Bonds payable

1 Transaction cost Cash Dec. 31 Interest expense

5,379,100 100,000 100,000 600,000

Cash (12% x 5,000,000) 31

Bonds payable Gain from change in fair value

600,000 79,100 79,100

Bonds payable--- January 1, 2013

5,379,100

Fair vak\lue--- December 31, 2013

5,300,000

Decrease in fair value of bounds-- gain

79,100

QUESTION 4-11 What is the meaning of treasury bonds? ANSWER 4-11 Treasury bonds are entity’s own bonds originally issued and re acquired but not canceled QUESTION 4-12 Explain the accounting for treasury bonds. ANSWER 4-12 When treasury bonds are required, the “treasury bonds account” is debited at face value and any related unamortized premium or discount or issue cost is cancelled. The difference between the acquisition cost and carrying amount of the treasury bonds is treated as gain or loss on acquisition of treasury bonds. Any accrued interest paid is charge to interest expense. Treasury bonds are reported in the statement of financial position as a deduction from bonds payable. QUESTION 4-13 What is meant by bond refunding? ANSWER 4-13 Bond refunding is floating of new bonds payable the proceeds from which are used in paying the original bonds payable. Simply stated, bond refunding is the premature retirement of the old bonds payable through the issuance of new bonds payable. QUESTION 4-14 What is the treatment of bond refunding charges? ANSWER 4-14 The refunding charges include the unamortized bond discount or premium, unamortized bond issuer cost and redemption premium on the old bonds being refunded. PFRS 9, paragraph 3.3.1 provides that the bond refunding is an extinguishment of a financial liability.

Paragraph 3.3.3 further provides that the difference between the carrying amount of the financial liability extinguished and the consideration paid shall be include in profit or loss. Accordingly, the refunding charges shall be accounted for as loss on early extinguishment of debt. QUESTION 4-15 Explain the effective interest method of amortizing discount on the bonds payable, premium on bonds payable and bond issue cost. ANSWER 4-15 The effective interest method or simply “interest method” or scientific method recognizes two kinds of interest rate- nominal rate and effective rate. The nominal rate is the rate appearing on the face of the bonds while the effective rate is the actual interest incurred on the bond issue. The effective rate is the rate that exactly discounts estimate cash future payments through the expected life of the bonds payable or when appropriate , a shorter period to the net carrying amount of the bonds payable. The nominal rate is also known as coupon or stated rate. The effective rate is also known as yield or market rate If the bonds are sold at a discount, the effective rate is higher than nominal rate. If the bonds are sold at premium, effective rate is lower than nominal rate.

AMORTIZATION OF BOND PREMIUM OR DISCOUNT The annual amortization of premium or discount is the difference between the effective expense and nominal interest expense. The effective interest expense is computed by multiplying the carrying amount of the bonds payable at the beginning of the year by the effective rate. The nominal interest expense is computed by multiplying the face value of the bonds payable by the nominal rate. Under the effective interest method, bond issue cost must be lumped with the discount on the bonds payable and netted against the premium on the bonds payabale.

QUESTION 4-16 Multiplied choices (PFRS 9) 1. Bonds payable not designated at fair value through profit loss shall be measured initially at a. Fair value b. Fair value plus bond issue cost c. Fair value minus bond issue cost d. Face amount 2. After initial recognition, bonds payable shall be measured at I. Amortized cost using the effective interest method. II. Fair value through profit loss a. I only b. II only c. Either I or II d. Neither I or II 3. Which of the following statements is true in relation to the fair value option of measuring a bond payable? I. At initial recognition, an entity may irrevocably designate a bond payable at fair value through profit or loss II. The bond payable is remeasured at every year-end at fair value and any changes in fair value are recognized in profit or loss. a. I only b. II only c. Both I and II d. Neither I nor II 4. The amortization cost of bonds payable means a. Face amount plus premium on bonds payable b. Face amount minus discount on bonds payable c. Face amount minus bond issue cost d. Face amount plus premium on bonds payable, minus discount on bonds payable and minus bond issue cost 5. Under the fair value optyion. Bonds payable shall be measured initially at a. Fair value b. Fair value plus bond issue cost c. Fair value minus bond issue cost d. Face amount ANSWER 4-16 1. C 2. C

3. C 4. D

5. A

Question 4-17 Multiple choice (AICPA ADAPTED) 1. Bonds that mature on a single date are called a. Term bonds b. Seriasl bonds c. Debenture bonds d. Callable bonds 2. Bonds are issued with scheduled maturities at various dates are called a. Convertible bonds b. Term bonds c. Serial bonds d. Callable bonds

3. Costs incurred in connection with the issuance of ten-year bonds which sold at a slight premium shall be a. Charged to retained earnings when the bonds are issued b. Expensed in the year in which incurred c. Capitalized as organization cost d. Reported as a deduction from bonds payable and amortized over the ten-year bond term 4. Unamortized debt discount shall be reported as: a. Direct deduction from the face amount of the debt b. Direct deduction from the present value of the debt c. Deferred charge d. Part of the issue costs 5. The issuer of a 10-year term bond sold at par three years ago with interest payable May 1 and November 1 each year, shall report at year-end a. Liability for accrued interest b. Addition to bonds payable c. Increase in deferred charges d. Contingent Liability 6. When the interest payment dates of a bond are May 1 and November 1, and a bond issue is sold on June 1, the amount of cash received by the issuer will be a. Decreased by accrued interest from June 1 to November 1 b. Decreased by accrued interest from May 1 to June 1 c. Increased by accrued interest from June 1 to November 1

d. Increased by accrued interest from May 1 to June 1 7. A bond issued on June 1 has interest payment dates of April 1 and October 1. Bond interest expense for the current year ended December 31 is for a period of a. Three months b. Four months c. Six months d. Seven months 8. The market price of a bond issued at a discount is the present value of the principal amount at the market rate of interest a. Less the present value of all future interest payments at the market rate of interest b. Less the present value of all future interest payments at the rate of interest stated on the bond c. Plus the present value of all future interest payments at the market rate of interest. d. Plus the present value of all future interest payments at the rate of interest stated on the bond 9. In theory, the proceeds from the sale of a bond would be equal to a. The face amount of the bond b. The present value of the principal amount due at the end of the life of the bond plus the present value of the interest payments made during the life of the bond c. The face amount of the bond plus the present value of the interest payments made during the life of the bond d. The sum of the face amount of the bond and the periodic interest payments 10. Under international accounting standard, the valuation method used for bonds payable is a. Historical cost b. Discounted cash flow valuation at current yield rate c. Maturity amount d. Discounted cash flow valuwation at yield rate at issuance ANSWER 4-17 1. a 6. d 2. c 7. d 3. d 8. c 4. a 9. b 5. a 10. d QUESTION 4-18 Multiple Choice (AICPA Adapted) 1. What is the effective interest rate of a bond measured at amortized cost? a. The stated rate of the bond

b. The interest rate currently charged by the entity or by others for similar bond c. The interest rate that exactly discounts estimated future cash payments through the expected life of the bond or when appropriate, a shorter period to the net carrying amount of the bond d. The basic risk-free interest rate that is derived from observable government bond prices. 2. For a bond issue which sells for less than face value, the market rate of interest is a. Dependent on rate stated on the bond b. Equal to rate stated on the bond c. Less than rate stated on the bond d. Higher than rate stated on the bond 3. What is the market rate of interest for a bond issue which sells for more than face value? a. Less than rate stated on the bond b. Equal to rate stated on the bond c. Higher than rate stated on the bond d. Independent of rate stated on the bond 4. If bonds are issued at a premium, this indicates that a. The yield rate of interest exceeds the nominal rate b. The nominal rate of interest exceeds the yield rate c. The yield and nominal rates coincide d. No necessary relationship exists between two rates. 5. Which of the following statements is true for a bond maturing on a single date when the effective interest method of amortizing bond discount is used? a. Interest expense as a percentage of the bond carrying amount varies form period to period b. Interest expense increases each six-month period c. Interest expense remains constant each six month period d. Nominal interest rate exceeds effective interest rate 6. How would the amortization of premium on bonds payable affect each of the following? Carrying amount of bond a. b. c. d.

Increase Increase Decrease Decrease

Net income Decrease Increase Decrease Increase

7. How would the amortization of discount on bonds payable affect each of the following ?

Carrying amount of bond a. b. c. d.

Increase Increase Decrease Decrease

Net income Decrease Increase Decrease Increase

8. An entity issued a bond with a stated rate of interest that is less than the effective interest rate on the date of issuance. The bond was issued on one of the interest payment dates. What should the entity report on the first interest payment date? a. An interest expense that is less than the cash payment made to bondholders b. An interest expenses that is greater than the cash payment made to bondholders. c. A debit to the unamortized bond discount. d. A debit to the unamortized bond premium. 9. A 20-year bond was issued at a premium with a call provision to retire the bond. When the bond issuer exercised the call provision on an interest date, the call price exceeded the carrying amount of the bond. The amount of bond liability removed from the accounts should have equaled the a. Cash b. Face amount plus unamortized premium c. Call price plus unamortized premium d. Current market price 10. A ten-year term bond was issued at a discount with a call provision to retire the bond. When the bond issuer exercised the call provision on an interest date, the carrying amount of the bond was less than the call price. The amount of bond liability removed from the accounts should have equaled the a. Call price b. Call price less unamortized discount c. Face amount less unamortized discount d. Face amount plus unamortized discount ANSWER 4-18 1. 2. 3. 4. 5.

c d a b b

6. 7. 8. 9. 10.

d a b b C

QUESTION 4-19 Multiple Choice (AICPA Adapted)

1. A five- year term bond was issued on January 1, 2012 at a premium. The carrying amount of the bond on December 31, 2013 would be a. b. c. d.

The same as the carrying amount on January 1, 2013 Higher than the carrying amount on January 1, 2013 Higher than the carrying amount on December 31, 2014 Lower than the carrying amount on December 31, 2014

2. A five-year bond was issued on January 1, 2012 at a discount. The carrying amount of the bond on December 31, 2013 would be a. Higher than the carrying amount on January 1, 2013 b. Lower than the carrying amount on January 1, 2013 c. The same as the carrying amount on January 1, 2013 d. Higher than the carrying amount on December 31, 2014 3. On January 1, 2013, an entity issued bonds at a discount. The bonds mature on December 31, 2017. The entity incorrectly used the straight line method instead of the effective interest method to amortize the discount. How is carrying amount of the bonds affected by the error? December 31, 2013 a. Overstated b. Overstated c. Understated d. Understated

December 31, 2017 Understated No effect Overstated No effect

4. If bonds are initially sold at a discount and the straight line method of amortization is used, interest expense in the earlier years a. Will exceed what it would have been had the effective interest method of amortization been used. b. Will be less than what it would have been had the effective interest method of amortization been used. c. Will be t...